On the USS investment strategy: comments and calculations
This is a USSbrief, published on 19 August 2019, that belongs to the OpenUPP (Open USS Pension Panel) series. It has been submitted by the author to the UCU-UUK JEP (Joint Expert Panel), with the title ‘Additional comments on scheme valuation and associated matters’, on 1 July 2019, amended 17 July 2019 to add Section 3. The author is a USS scheme member, a member of the University of Sheffield USS Working Group, a UCU-elected JNC member (June 2018-present), and is writing in a personal capacity.
1. Comments on USS investment strategy
1.1. Comparison with Defined Contribution (DC) investment strategies
It is often claimed that pension liabilities should be discounted at or near the risk-free rate, part of the rationale being that pensions in payment have ‘bond-like’ characteristics. However, this claim overlooks what should be an important consideration in calculating future service costs, namely that the payments for pension promises are deferred until retirement (which is decidedly not ‘bond-like’). This allows for a growth-phase, which could — arguably, should — be explicitly accounted for.
A comparison with common approaches to investment of individual DC pots (sometimes referred to as ‘lifestyle strategies’) shows that contributions made to fund promises could — arguably, should — be invested in growth assets, at least until retirement is approaching. Any investment in bonds and the like to ‘match’ outflows could — arguably, should — be limited by the portion of the liabilities relating to pensions in payment. For an open, ongoing scheme such as USS, where incoming contributions cover the outflows, there is an argument that even this is would be an unnecessary level of investment in fixed-return assets, as the certainty in the cashflows generated by the investments is not required while the scheme remains open.
1.2. Effect on discount rates
The argument above would lead to the following conclusions about the discount rate:
- A different rate would be applicable to future service costs than to liabilities on past service
As every promise made would consist of a growth-phase (combined with a partial move to bonds on the approach to retirement, if desired), this would determine an investment strategy for the contributions relating to that promise. Aggregating the investment strategies over the total Year 1 contributions, say, would then result in a strategy for that year’s inflows, which would determine a corresponding discount rate and hence a future service cost.
The figure that would be arrived at above would likely be different from that appropriate for past service, though the rough idea is the same: every promise carries with it an investment strategy, and the aggregated strategies would give an overall strategy and an associated discount rate.
2. Future service costs would be likely to fall
An investment strategy and discount rate for future service based explicitly on a long growth phase before retirement would be likely to show that the benefits do not cost as much as is often claimed. The effect on past service would depend on how much of a move to bonds is deemed appropriate to cover pensions in payment.
2. Interaction with regulation
I believe the regulation of Defined Benefit (DB) schemes allows for a different discount rate to calculate future service costs as opposed to liabilities on past service (and USS adopted such an approach themselves in the past). Whether the approach suggested above would be within the regulation would need clarifying.
3. Rough calculations
I attach a spreadsheet which attempts to estimate the split between a growth and low-risk portfolios implied by the arguments above. The conclusions from these calculations need to be treated with some caution owing to the unscientific methods used to generate the estimates.
The spreadsheet comprises two tabs: one for future service and one for past service. Figures for the numbers by age-bracket for active, deferred and pensioner members were taken from USS’s 2018 Annual Report. Estimates including average age, wage, lifespan, years to retirement, years’ service and pensions in payment as a proportion of total liabilities were made in a very rough and ready fashion and should be treated with caution. A proposed investment in a growth portfolio until 10 years from retirement, then a linear de-risking to a low-risk portfolio over the next 10 years is assumed, which is similar to USS’s ‘lifestyle fund’ in the DC section of the scheme.
The conclusions from the spreadsheet indicate that future service costs should, if following the logic outlined above, use a discount rate based on a very different asset mix from the past service liabilities (at least 90% invested in a growth portfolio for future service compared with at least 60% for past service). This would have a significant effect on future service costs, and give a fairer indication of the cost of providing the pensions.
This is a USSbrief, published on 19 August 2019, that belongs to the OpenUPP (Open USS Pension Panel) series. It has been submitted by the author to the UCU-UUK JEP (Joint Expert Panel), with the title ‘Additional comments on scheme valuation and associated matters’, on 1 July 2019, amended 17 July 2019 to add Section 3. The author is a USS scheme member, a member of the University of Sheffield USS Working Group, a UCU-elected JNC member (June 2018-present), and is writing in a personal capacity. This paper represents the views of the author only. The author believes all information to be reliable and accurate; if any errors are found please contact us so that we can correct them. We welcome discussion of the points raised and suggest that discussants use Twitter with the hashtags #USSbriefs78 and #OpenUPP2018; the authors will try to respond as appropriate. This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License.